Bernanke’s Prognosis & Prescription for State, Local Governments

The state and local fiscal crisis is going to get worse before it gets better, says the nation’s most powerful economist, Federal Reserve Chairman Ben Bernanke.

But, the former member of a local school board in New Jersey adds: Don’t starve education. It is vital for future economic growth

“Despite the many difficult adjustments to date, state and local fiscal repair is far from complete, and governors, mayors, and legislators will confront more tough decisions as they develop their budgets for fiscal year 2012,” the Fed chief said in a speech to New York City’s Citizens Budget Commission Wednesday evening.

“Although the economy is recovering,” he said, “it is still operating well below potential and unemployment remains high. Stimulus grants from the federal government are winding down this year and will largely have ended by 2012,” he added. “Demands on Medicaid and other social service programs will likely remain elevated. Moreover, reserve funds are low, and the list of unused one-time fixes has been substantially depleted.”

“If the economy continues to strengthen at about the pace projected by the Federal Reserve and many private forecasters, states and localities may start to get a little breathing space,” he said. “Tax collections will rise with income and spending, and the use of Medicaid and other income support programs should ease as the labor market improves.”

But his bottom line was far from upbeat: “Because the pace of near-term economic growth expected by most forecasters is relatively modest given the depth of the downturn, some time will likely be required before state and local fiscal conditions return to something approximating normal.”

So what does Bernanke advise? Well, one big near-term problem is financing public-employee retirement and health plans. “With the retirement of public employees who are part of the baby-boom generation and the continued rise in health-care costs, meeting obligations for pension and retiree health-care expenses will become increasingly difficult,” he said.

But a longer-term issue to is reduce the vulnerability of state and local tax revenues to the ups and downs of the economy. “An important question is whether anything can be done to reduce the sensitivity of state and local budgets to the business cycle. As the past couple of years have shown, the balanced-budget rules under which most states operate can force sharp cuts in services and increases in taxes during recessions, which is just the time when many people in the state are economically most vulnerable. Moreover, the instability in funding streams and tax rates associated with the business cycle can impede planning by both the public and the private sectors.” he said.

How?

–Preserve current rules that require state operating budgets to balance, but build up bigger rainy day funds in good times to tap in bad ones. Those funds amounts to 11.5% of state budgets in 2006, but that proved inadequate for the deep recession, he said. “Governments may wish to revisit their criteria for accumulating and using fiscal reserves. Building an adequate reserve fund during good times may not be politically popular, but doing so can pay off during bad times as well as lessen the tendency to overspend when times are good.”

–Use capital budgets to “smooth” spending over good times and bad. “In particular, maintaining or even increasing the pace of construction spending when the economy is weak could add valuable infrastructure and provide local jobs; it may even allow a government to get more “bang for the buck” because of increased competition among private contractors when demand is slack. Voters and policymakers may understandably be reluctant to approve new bond issues and take on additional costs for debt payments in a period of fiscal and economic stress, but they might be less reluctant if governments were to accumulate larger rainy day funds and assign a higher priority to tapping them for infrastructure purposes in times of economic weakness.”

–Rethink state tax codes. “Their revenues–always sensitive to economic conditions–appear to have become even more tied to the economy over time. One reason for this greater sensitivity is that capital income, which tends to vary substantially more than wage and salary income, has become an increasingly important source of state personal income taxes. Also, sales taxes may have become more cyclical because of an increasing tendency to exempt certain necessities, for which demand is relatively more stable. As state legislatures review their tax systems, they may wish to consider steps to enhance the cyclical stability of their revenue streams.”

–Don’t starve education, a/k/a “ensuring an adequate investment in human capital–that is, in the knowledge and skills of our people.” “No economy can succeed without a high-quality workforce, particularly in an age of globalization and technical change. Cost-effective K-12 and post-secondary schooling are crucial to building a better workforce, but they are only part of the story. Research increasingly has shown the benefits of early childhood education and efforts to promote the lifelong acquisition of skills for both individuals and the economy as a whole. The payoffs of early childhood programs can be especially high. For instance, preschool programs for disadvantaged children have been shown to increase high school graduation rates. Because high school graduates have higher earnings, pay more taxes, and are less likely to use public health programs, investing in such programs can pay off even from the narrow perspective of state budgets; of course, the returns to the overall economy and to the individuals themselves are much greater.” With so many workers still looking for jobs and the demand of the job market changing so rapidly, Bernanke also made the case for education for adults. “For example, community colleges and vocational schools train and retrain workers, often in close collaboration with private employers, and in many cases they perform this function at a relatively low cost. Although helping workers acquire up-to-date skills is always important, it is especially critical now, when long spells of unemployment are threatening the longer-term employability and productivity of many.”

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